What is a Security?

08/03/2021

What is a security? Many entrepreneurs express surprise at the broad scope of the definition as well as the serious implications from failing to abide by securities laws. This section first addresses those implications and then discusses when the securities laws apply by virtue of a security being involved.

The Implications of Selling a Security
When a business offers and sells a security to potential investors, the business must consider the potential application of three primary and separate areas of securities laws:

(a)Registration of the security being sold;
(b)Registration of the business and individuals selling the security;
and

(c)Disclosure of adequate information relating to the security
(through a private placement memorandum, prospectus or otherwise).

Both Federal and Utah securities laws include all three areas, and if a business receives money or other types of investment without compliance or an exemption, it risks being found liable for securities fraud and other civil and even criminal penalties. Moreover, the standard for securities fraud is much lower than for common law fraud, and non-compliance not only puts the business at significant risk, but the business’ principals can be held individually liable too.

For example, if a company offers or sells securities without accurate and complete disclosure concerning the nature and risks of the securities and the business, the investors can later sue the company and its principals to get their money back, with interest. Such a suit can succeed even if the company’s floundering did not arise from mismanagement or from any bad faith or wrongdoing. Furthermore, both the U.S. Securities & Exchange Commission and the Utah Securities Division can independently bring actions against non-complying businesses and individuals.

What Constitutes a Security that Makes Securities Laws Applicable? Stock and Debt. Federal and Utah statutes define the term “security” to include any stock, note, bond, debenture or evidence of indebtedness. 15 U.S.C. §77b(a)(1); Utah Code § 61-1-13(1)(ee)(i). Many properly assume that a security includes any corporate stock, especially if the stock is sold on a stock exchange. However, as noted, a security includes any stock, even if in a very small or “Mom and Pop” enterprise. Furthermore, the sale of a business through a stock sale involves the sale of a security. Landreth Timber Co. v. Landreth, 471 U.S.

681 (1985).

As noted in the security definitions, promissory notes and other evidences of loan or debt also constitute securities. Consequently, if a company seeks investment by means of stock ownership or by receiving a loan, the transaction involves a security subject to securities laws. A note, evidence of debt or other security can involve a security whether profit or interest accrues at a fixed or a variable rate, and whether the investment is guaranteed or stated as “low-risk.” See, SEC v. Edwards, 540 U.S. 389, 394 (2004).

Investment Contracts; Profit-Sharing Arrangements. Federal and Utah security definitions expressly list any “investment contract” and any “certificate of interest or participation in a profit-sharing agreement.” 15 U.S.C. §77b(a)(1); Utah Code § 61-1-13(1)(ee)(i). These terms address a multitude of other investments that constitute a security by virtue of an enterpise offering an investor a profitable return in one form or another.

In the landmark case of SEC v. W.J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100 (1946), the U.S. Supreme Court found that land sale contracts for Florida citrus groves, combined with a 10-year service contract to manage the groves, were investment contracts – and therefore securities. In now iconic securities language, the Supreme Court held that an investment contract “means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” 66 S.Ct. at 1103.

Utah has adopted statutory language that is very similar to the Howey decision, stating that an investment contract (therefore, a security) includes “an investment in a common enterprise with the expectation of profit to be derived through the essential managerial efforts of someone other than the investor.” Utah Code § 61-1-13(1)(s)(i).

In addition, a second Utah definition of “investment contract” includes an investment by which:

an offeree furnishes initial value;
that is subjected to risks of the enterprise;
with representations that give rise to a reasonable understanding that the offeree will receive a valuable benefit beyond the initial value; and
without the offeree having a right to exercise practical and actual control over the management decisions of the enterprise. Utah Code § 61-1-13(1)(s)(ii).

The Howey case and the Utah investment contract definitions clearly show that various transactions and schemes can be found to be securities despite the label given to the transactions by the parties. Countless profit-sharing arrangements have been found to be investment contracts, including sales of franchises and real estate and participatory shares in cemetery lots, mining claims, and fishing boats.

Since the real estate downtown of 2006 to 2012, many more entrepreneurs have offered to assist investors in acquiring homes or other real estate for rental, improvement or sale or in making loans for real estate projects. The entrepreneurs often accompany their offers with various levels of management assistance. These investments should be analyzed to determine whether they constitute securities that require compliance with the securities laws.

If an investor invests value in an enterprise expecting a profitable or valuable return due to efforts of others or without a meaningful management role, that investor can avail himself of the protections and remedies provided under the securities laws. Therefore, a company making an offer or sale to that investor must address each area of securities compliance.

LLC Interests. Across the country, limited liability companies (LLCs) are now formed more frequently than corporations. Utah’s security definition expressly includes any “interest in a limited liability company.” Utah Code § 61-1-13(1)(ee)(i)(Q). While the Federal Securities laws do not expressly list LLC interests as securities, judicial determinations frequently rule them to be securities, unless a competent and experienced investor has meaningful control over the LLC. See, Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003); SEC v. Merchant Capital, 483 F.3d 747 (11th Cir. 2007); and United States v. Leonard, 529 F.3d 83 (2d Cir. 2008).

Pre-sale Offers, Certificates and Deposits. Some may assume that the securities laws do not apply until the enterprise actually issues and sells the security. However, Federal and Utah securities statutes also include any:

preorganization certificate or subscription,
certificate of deposit for a security, or
certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, a security. 15 U.S.C. §77b(a)(1); Utah Code § 61-1- 13(1)(ee)(i).

These terms clearly include any document evidencing an intent or agreement to purchase a security in the future. In fact, besides the inclusiveness of the security definition, the securities laws expressly apply to offers of securities, even if a sale never takes place. Accordingly, wise entrepreneurs consider securities implications prior to even discussing investment with a potential investor.

Other Types of Securities. Federal and Utah securities statutes list many other types of securities that are not specifically addressed here. The statutes also expressly identify other transactions or instruments that are not deemed to be securities. Case law developed through litigation also amplifies and reduces the respective security definitions.

Security Involved Regardless of the Value Given and with Each Investment Decision
As noted in the investment contract definitions, the nature of the investment given for a security is not limited to cash. An investor can give value through exchange of services, goods, future promises, or any other consideration. For example, businesses may give equity ownership or stock options to employees for services rendered without realizing that these are securities transactions.

Some investments require that an investor make an initial payment and then subsequent installments. Other investments may obligate the investor to make an infusion of additional capital under certain circumstances or may make the additional contributions voluntary. Also, sometimes businesses offer to repurchase or redeem stock or other equity interests owned by existing investors.

While the initial investment offering and sale may have been made in full compliance with securities laws, separate analysis and compliance should be made as to the subsequent investment or divestment requirements or possibilities. In these cases a new investment decision faces the investor. He must decide whether to give value in exchange for something in return, even though he may be obligated to do so. Businesses should evaluate and comply with the applicable securities laws at these times too.

If a Security is Involved, What Next?
When a business plans to offer or sell a security, the business should next explore whether an exemption exists that excuses compliance with one or more of the areas of securities regulation. The private placement exemption (under Regulation D or otherwise) often exempts some businesses from securities registration, but qualification for the exemption requires some important analysis and steps that are described in a following section.

However, that exemption does not free a business from compliance with the disclosure or anti-fraud provisions of the securities laws or from evaluating whether the sellers of the securities are required to be registered.

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